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We Should Have Seen Exxon's Bad Quarter Coming

Everyone seemed surprised when Exxon had a bad quarter, but the reasons were staring us right in the face.

It's not very often that we see a company like ExxonMobil's(NYSE:XOM) earnings drop by 57% from the previous year. In all honesty, though, we should have all seen it coming. While a large portion of that epic drop isn't much to worry about, there are a few items that investors should be aware of. Let's break down this earnings flub and see how if we can gather some insight into how it will affect Exxon in the future.

A Tale of Two QuartersThe biggest reason Exxon's management gave for the large drop in earnings is from restructuring its Japan assets. This statement is actually a little deceiving, though. It wasn't that the company realized a large loss this past quarter when it spun off its Japanese refineries and chemical plants, but rather the company realized a $5.9 billion gain on the sale the year prior. By looking at the company's past six quarters of earnings, we can see that the second quarter of 2012 was just as much an exception as this past one.

So adjusting for the Japan deal and the $1 billion gained from selling other assets, the company's earnings the year prior were about $9 billion. This actually puts the company's earnings more in line with what it did throughout 2012, so that 57% earnings drop is a little overstated. At the same time, it doesn't account for the 27% drop from the previous quarter. To understand that, we need to dive deeper into the heart of Exxon's operations.

A nick here, a scratch there

Normally when an oil company says it lost something in the range of hundreds of millions of dollars in a quarter, investors would be petrified. For Exxon, though, a miss of a hundred million won't break the company. When several of those losses compile over a single quarter, though, it can really add up to something. This quarter we saw declining production from OPEC mandated quotas, maintenance downtime, weak refining margins, and weaker pricing on specialty chemicals. Ultimately, all these small nicks in Exxon's armor piled up to a $1.6 billion drop in earnings. While there are several reasons for this, almost all of these issues can be boiled down to two drivers.

Need for new projects: Exxon had a working interest in over 100,000 gross wells producing at the end of 2012, each of which is in some stage of decline. This massive catalog of wells coupled with things like shutting-in production from wells it has in OPEC nations and basic maintenance means that Exxon needs to do lots of drilling and development just to maintain production. So unless new major projects come online in a quarter, then there will more than likely be either flat or declining production.

Portfolio Balance: Exxon's current operations are not very well positioned to take advantage of what is going on in the United States right now. Most of the company's oil and gas production is outside the US, while its largest share of refinery capacity is domestic. This was one of the worst positions to be in last quarter as international crude prices fell and domestic crude prices increased, which led to margins falling in both business segments. Conocophillips(NYSE:COP), in contrast, was well positioned to take advantage of the current market because it has focused more on North American oil and gas development and it spun off its refineries into a separate company a year previous. Conoco's US oil production grew 47% year over year, and it showed to be the winning strategy for this previous quarter.

These two drivers are not glaring weaknesses in Exxon's strategy, but they can certainly cause an earnings hiccup from time to time. So far this year its Kearl oil sands joint venture with Imperial Oil(NYSEMKT:IMO) has been the only major project to come online, but it is not yet running at full capacity. Once this project ramps up, it should be enough to offset declines elsewhere and grow production.

Long term, oil sands will become a major part of Exxon's strategy, which will address both of the issues above. Not only does it bring online some major production capacity, but it is also going to focus the company's portfolio more on the North American market. This project, as well as its $4 billion exploration project with Statoil(NYSE:STO) in the Gulf of Mexico, should significantly help Exxon turn around these recent woes.

What a Fool Believes

Understanding how an integrated oil company ticks can be a daunting task. Once you have that working knowledge, though, it can be a little easier to foresee what will be coming down the pipe for the next few years or so. The major projects that Exxon has coming up should result in a decent uptick in production, but the question remains if some of these projects can live up to Exxon's lofty goal of achieving a 25% return on capital employed. That answer depends greatly on how Exxon can execute on these projects coming down the pipe.

Fool contributor Tyler Crowe has no position in any stocks mentioned. You can follow him at Fool.com under the handle TMFDirtyBird, on Google +, or on Twitter: @TylerCroweFool.